Passive V Active – Which is healthy for you? Part 1

Traditionally, investors have appointed investment managers to (actively) manage their exposure to asset classes – their asset allocation – and individual assets within each asset class – asset selection. Fund managers charge a fee for their service of constructing portfolios for their investors – either at the asset class or individual asset level, or both. In return for this they try to outperform their benchmarks. In the case of asset selection it would be something like the FTSE, MSCI or S&P500. They do this by identifying assets (shares in this case) that will outperform the combination of assets that make up the benchmark. Fund managers’ value proposition is that their skill in selecting assets (or asset classes) produces sufficient out-performance against the relevant benchmark to justify their fee.

Passive products differ from active products in two key ways. Firstly, individual assets are selected on a mechanical basis; and secondly their fees are significantly lower. The first generation of passive products was designed to replicate the returns of benchmarks such as the aforementioned. The range of these products has been broadened to include index tracking funds covering specialised indices that concentrate on a particular sector, e.g. commodities or technology, etc.

Other, more recent versions try to improve on this in systematic (i.e. mechanical) ways. Some use different measures to market capitalisation (the way the FTSE, etc., is constructed) to build their portfolios. The latest evolution in the passive space includes the so-called ‘Smart Beta’ products. They use pre-determined (i.e. mechanical) investment strategies to give investors consistent exposure to a particular investment style or outcome. Examples include value and momentum style portfolios and risk managed portfolios such as the minimum volatility (min-vol) product. These products all construct their portfolios using a fixed methodology or set of rules.

The ‘style’ funds such as value and momentum products systematically identify the presence of these ‘factors’ and construct portfolios of equities which embody them. In the case of the min-vol portfolios, they are constructed in such a way as to minimise the volatility of the returns of the portfolio using average historical returns and variance/co-variance matrices. As with all passive products the fees are low as the ‘recipe’ is fixed and the portfolio manager merely oversees its application.

Passive products have been around for a while in their various guises but it is only recently that they are getting more widely used in the many more markets. Why the delay? We believe that most investors tend to view them as direct alternatives, or substitutes, to the traditional active funds. If it is framed in this way, the debate immediately becomes one of ‘either/or’ – in other words: which approach is better than the other?

Comparisons are most often then made between the lower fees of the passive funds vs. the (often temporary) out-performance of the active managers. Somehow the idea of buying consistently average performance is not that exciting – even when it’s very cheap! However, as customers become more familiar with the concept of passive products and their relative advantages they are beginning to choose them more often. The relatively low returns environment offshore has also pushed investors there into using the cheaper passive investments to save on the negative impact of costs on their (already low) returns.

A more productive perspective is to view these two investment approaches as complementary to other – they can both play different, but equally important, roles in a portfolio. Passive products allow us to get very precisely targeted, consistent exposures to asset classes and investment strategies at a relatively cheap price.

We value this highly, given the importance of asset allocation in our investment process. The more recent developments in this field, such as the Smart-Beta products, allow us to get consistent exposure to investment strategies that were previously only available via active managers (e.g. value, momentum or high yielding equities). Furthermore we had to hope that active managers would implement these strategies consistently – in other words, there was no style drift. Now we can be certain of this outcome if we go the Smart-Beta route.

To be continued…

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]